There are many in the professional investment community who seem to be misinterpreting both the intent and effectiveness of the Fed’s Quantitative Easing strategy. As a result these folks are discounting and denying the current bull market. In the past few months you’ve probably heard somebody say or read a similarly-worded headline—“Is this rally for real?” What do these people mean by that?
What they really mean is probably closer to “How long can this rally continue?” or “Wait- the Dow is where? How did that happen??” The implication is that Ben Bernanke and his team of interns are churning out crisp hundred dollar bills by the truckload via caffeine-fueled all-nighters at the Federal Reserve’s printing press headquarters. Aren’t asset prices simply adjusting upwards until all the new bills have found their proper homes? Very little consideration is being given to the positive side effects, aside from just increased liquidity, of Quantitative Easing.
Quantitative Easing with Mrs. Fields
It’s not quite as simple as some of the Fed-haters would have you believe. We hear about home sales ticking higher, companies reporting record profits, unemployment gradually sliding down to somewhat acceptable levels. The quick retort of “Yeah, but they’re just printing money, none of this demand is legit” argument is both ignorant and binary. It’s like hearing Mrs. Fields report record quarterly sales and spouting off “Nobody’s spending money on stuff like that anymore, she’s probably eating all those cookies herself and fudging the numbers!”
Is it possible that Ben Bernanke and his Quantitative Easing strategy are having the desired effect and some of us just don’t like it? Is it possible that the reason some of us don’t like it is because it’s not helping them as much as it’s helping everybody else?
Let’s face it — things have not gotten better for everyone. There are those unfortunate who lost jobs/income over the past five years and still struggle with un- and under-employment. It has been brutal for some of these families. I know many who have been forced to downsize, relocate, reinvent themselves, and in some cases it still hasn’t been enough. Having been in asset management for the past ten years, I have certainly taken my share of lumps. But I absolutely refuse to believe that we are not on the right side of this swinging pendulum.
The Curious Case of Benjamin Bernanke
The case we are talking about has nothing to do with Ben Bernanke aging, or aging in reverse, but it does have to do with our country’s aging population.
Low interest rates discourage individuals from saving but encourage lending, spending, and investment (good for economic growth). According to some of the most catchy headlines, however, QE is working much to the detriment of our aging baby boomer generation. Retirees counting on interest and bond coupon payments to meet their income needs lose out from low interest rates, right? I’m not so sure.
Another by-product of falling interest rates is appreciation in fixed income assets. Over the past two decades bond prices have appreciated dramatically as interest rates have fallen.
Below is a chart reflecting the downward trend in yield (and therefore upward trend in price) on the 30-year Treasury Note. Keep in mind that many factors — duration, credit quality, call features (to name a few) — influence the prices of bonds in your portfolio.
Let’s say twenty years ago you built a run-of-the-mill bond portfolio — made up of Treasury Bonds, Government Agencies, High Grade Corporate Debt, and even throw in some Junk (High Yield) for good measure. At that time the 30-year Treasury was about 7%. Since then, some of your bonds have matured and others have been called; others, though, are trading well above what you paid. I think it is reasonable to assume that such a portfolio has appreciated by 20% over the past twenty years. Now that rates have moved and some of your bonds have been called, you are faced with the unfortunate reality of reinvesting any new money at much lower rates — in some cases it’s not much better than holding cash.
But let’s be honest, haven’t you made out like a bandit? If your bonds have gained in value by 20% you’ve got four years’ worth of interest payments sitting in your account. Sure, it’s not spinning off the same interest income today as it once was — but just because it doesn’t show up in your mailbox in the form of a monthly check doesn’t make it worth less, does it? Can’t you take your profits (sell those bonds), use your gains as you see fit, and gradually dip your toes back into the fixed income waters when rates start to rise again? Fixed income investors really ought to be thanking Mr. Bernanke, taking the unexpected appreciation in their bond portfolios to the bank (or supermarket/pharmacy).
“Yeah, but I don’t want to pay taxes on those gains….”
Okay, then don’t do it. Or perhaps you can take a loss elsewhere in your portfolio to offset the gain. Or maybe you have tax loss carry forwards from years past. Or maybe there is yet another way to adapt to changing circumstances….
So that’s all well and good, but, Is this rally for real? Can we really go higher from here? Yes, absolutely. Until we see even modestly attractive prospects in the bond market or elsewhere, TINA (There Is No Alternative).
Have a great week!
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main